Why Cohabiting Couples Should Consider Marriage or Civil Partnership to Protect Pension Assets from Inheritance Tax

Understanding the Proposed Inheritance Tax (IHT) Changes on Pension Assets

With the Government’s recent indication in the 2024 budget that pension assets may become subject to inheritance tax (IHT) upon the owner’s death, cohabiting couples could face unexpected financial implications. While spouses and civil partners continue to be exempt from IHT on pensions, unmarried partners who inherit these assets may incur a significant tax liability.

Yet, the impact of this change varies depending on the type of pension scheme: public sector schemes, defined benefit schemes, and money purchase schemes each have unique characteristics. Here’s a closer look at how these proposed IHT changes may affect cohabiting couples and why formalising their relationship through marriage or a civil partnership may offer essential protections.

 

1. Money Purchase Schemes: Avoiding a Significant Tax Burden

Money purchase (or defined contribution) schemes are generally made up of contributions that are invested, with the final pension pot depending on investment performance. Under current rules, spouses and civil partners can inherit these funds free of IHT, whereas cohabiting partners would be subject to up to 40% tax on the inherited pension pot.

Given that many private-sector employees rely on money purchase schemes, cohabiting couples in these circumstances might want to consider formalising their relationship to ensure the pension is transferred tax-free. This can help the surviving partner maintain financial stability without a large portion of the inherited pension pot being lost to tax.

 2. Defined Benefit Schemes: Nuances in Inheritance Rights

Defined benefit schemes—often found in larger companies or longstanding private sector businesses—typically provide a fixed pension income based on the employee’s salary and years of service. While many defined benefit schemes do offer survivor benefits, the eligibility criteria for these benefits can be more restrictive. Spouses and civil partners are often automatically entitled to survivor benefits, while cohabiting partners might not be covered unless explicitly nominated (where nomination is possible).

Under the new IHT rules, even where a cohabiting partner is eligible to receive a defined benefit pension, this income could be subject to tax upon inheritance. By entering a marriage or civil partnership, couples can help protect the full value of this benefit, as it will be exempt from IHT for a legally recognised surviving spouse or civil partner. Cohabiting couples with defined benefit pensions may, therefore, want to explore formalising their relationship to safeguard these income benefits.

 3. Public Sector Pensions: Protection for Spouses and Civil Partners

Public sector pensions often follow more structured rules around survivor benefits, typically extending full benefits to spouses and civil partners but not always to cohabiting partners. For instance, schemes for teachers, NHS workers, and civil servants may have stringent regulations around who qualifies for survivor pensions, with an emphasis on legal marital or civil partnership status.

Cohabiting partners without legal recognition may, therefore, face barriers to inheriting the public sector pension altogether, depending on scheme-specific rules. With the added possibility of IHT on pension assets, formalising the relationship can not only help secure access to survivor benefits but also ensure these assets pass tax-free.

 4. Additional Considerations for Cohabiting Couples

The proposed IHT rules mean it’s important for cohabiting couples to re-evaluate their estate planning, especially in terms of pensions. Those with money purchase pensions may face the most direct tax implications, while defined benefit and public sector pensions bring different inheritance challenges, often restricting eligibility to married or civilly partnered survivors. With that in mind, couples should consider:

Nomination Forms and Beneficiary Designations: Where possible, cohabiting couples should ensure they have completed any relevant nomination forms or made necessary beneficiary designations. This step is essential but may not provide the same security as marriage or a civil partnership.

Legal Planning and Financial Advice: Cohabiting couples may wish to consult with legal and financial advisors to evaluate their options based on their specific pension arrangements and overall estate. This advice can help them make an informed decision about formalising their relationship to mitigate potential tax implications.

Exploring Civil Partnership as an Alternative to Marriage: For those not ready to marry, a civil partnership offers a legally recognised relationship status and access to the same IHT exemptions as marriage. This could be a practical choice for couples concerned about protecting their pension assets.

In Summary: How Marriage or Civil Partnership Can Protect Pension Assets for Cohabiting Couples

With the Government’s proposed IHT changes, pension assets may face a tax liability when inherited by an unmarried partner. However, this impact varies by scheme type, with money purchase scheme holders likely to see the greatest tax burden, while public sector and defined benefit schemes introduce additional survivor benefit complexities.

Marriage or civil partnership provides a straightforward way for cohabiting couples to protect these pension assets, preserving them tax-free for the surviving partner. Whether you have a public sector, defined benefit, or money purchase pension, a legally recognised relationship can be invaluable in ensuring that pension assets remain intact for the care and support of the surviving partner.